Navigating Your 401(k) Plan- Part II

Last month I wrote an article that many readers on Seeking Alpha said they would like to see more of. It concerned how to navigate the choices in one’s 401(k) plan. I would like to follow up on that article with some more information on how to get the most out of your plan.

Most investors understand that they should be putting away at least some money into their 401(k) plan if they have one. And most understand that a company match is a very nice benefit to have. But a lot of people never really quantify just how important a good 401(k) plan can be.

I want to look at a few examples that will highlight how the different characteristics of some 401(k) plans can have a massive impact on the value of your portfolio once you retire, especially if you start contributing when you’re young.

Let’s look at an example of a young person, let’s call him John, who plans on retiring in 40 years. John currently makes $70,000 a year, has $20,000 in his 401(k) plan today, and contributes 5% of his income to the plan. Also, the company matches 50% of John’s contributions up to 5% of his income. So the company will stop matching after he has contributed .05 * $70,000 = $3,500. I also assumed a 3% raise each year for John. Lastly, the real return (after inflation) is assumed to be 3%. Using the real return presents numbers in today’s dollars so that they’re easier to comprehend.

Using our free calculator called 401k Benefits, I found that at retirement John will have $634,900. If not adjusted for inflation, the amount is over $1.2 million. During the 40 years John contributes to the plan, his company would have contributed almost $136,000 to his portfolio.These findings are presented below.

Balance Today

Balance in 40 Years

Amount John Contributes

Amount Company Contributes

Amount Due To Investment Growth

$20,000

$634,909

$271,822

$135,911

$227,176

(Click chart to expand)

In order to see just how important the matching aspect is, I set the company match to 0%. What I found is as follows:

Balance Today

Balance in 40 Years

Amount John Contributes

Amount Company Contributes

Amount Due To Investment Growth

$20,000

$379,904

$271,822

$0

$108,082

Under this scenario, John’s total 401(k) balance will only be $379,904 when he retires. That is a stark difference of over $255,000 just because of the company match.

When discussing a 401(k) plan, or any investment for that matter, it’s very important to look at the annual expenses of each fund or ETF. Too many plans have limited choices with high annual expense ratios. Let’s take a look at what high fees can do to your portfolio. Using the same starting example above, I added another 1% on for higher fees. The higher fees take 1% out of the portfolio’s return each year. This scenario gives us the following:

Balance Today

Balance in 40 Years

Amount John Contributes

Amount Company Contributes

Amount Due To Investment Growth

$20,000

$489,599

$271,822

$135,911

$81,866

Notice how far the Amount Due To Investment Growth has fallen from the original example. It dropped from over $227,000 to slightly under $82,000. The compounding of fees over time can have a very serious impact on your investments, as I pointed out previously in this article.

Given enough time, a good 401(k) plan can give you a portfolio at retirement that may be all you need to retire on. However, the rules for company matching and the annual expenses you pay on the investments have an enormous impact. While many employees cannot do anything about the company match except complain to human resources, it is usually possible to pick investments with lower fees in the plan itself.

I’ve also received questions about hedging against another credit meltdown by buying precious metals in one’s 401(k) plan or IRA. I own a gold ETF (NYSEARCA:SGOL) in my IRA rather than in my taxable account simply because any gains on gold are taxed at the full income tax rate and not the capital gains tax rate. I have come across 401(k) plans that offer precious metals funds, such as Vangaurd’s VGPMX. They are not 100% in gold, but they do offer a mix of gold, silver, and platinum, which are all hedges in their own way against financial turmoil. And because they are in a tax-deferred account, the gains are not taxed until you withdraw the money in retirement.

Another piece of advice, whether it’s in taxable or tax-deferred accounts, is to stay away from the actively managed, high cost funds if you can. If your plan offers index funds or lower cost ETFs, those are the places to put your money for the long-run. More companies are beginning to offer ETFs such as Vanguard’s S&P 500 ETF (NYSEARCA:VOO), which charges an astonishingly low .06% per year. Also, more plans are beginning to offer indexed emerging market ETFs such as EEM. Not only does this give investors access to non-US markets and the ability to diversify, but the fees are much lower than actively managed emerging markets funds.

At the very least, if your company has a 401(k) plan with a good matching component, make sure you max out your contributions at least to the point where your company stops contributing. And it also might go without saying that, in general, you should put your savings into your 401(k) plan first, then into other tax-deferred plans, and then into taxable accounts.